Real Estate Investors – Are You a Bug In Search of a Windshield?

I’ve been that bug on the windshield — three times. Only once was it due to outside forces — a politically powerful county supervisor wanted nobody in his fiefdom to prosper but him. We were dead in the water from the get-go. A lesson learned. The other times were due to me defying what I’ve come to call investment physics. Though certainly you could categorize my approach as OldSchool, investment physics knows no ‘school’. They work every time they’re tried — like gravity, either for, or against us.

Gravity is a part of our daily lives. We all have a healthy fear of it in the right circumstances. We might act crazy on a diving board three feet above the water in our backyard pool, but put us on the roof at a downtown penthouse bar, and crazy doesn’t enter our thought process as we peer over the edge, 30 stories down.

Same gravity — different consequences — same law of physics.

Leverage is a lot like gravity. It works every time it’s tried — one way or the other. Also like gravity, it doesn’t care which way it’s utilized — it just works. Gravity never, ever makes us fall up when jumpin’ off the top of a five foot fence onto the ‘soft’ grass below. I know that from personal experience — and my Superman cape helped not one iota. 🙂

Problem is, unlike gravity, the consequences of which most folks can at least accurately explain, most investors think the primary definition of leverage has to do with the size of their down payment on a piece of property. “I got some great leverage on this one. $0 down!”

Watch out for that….splat!…….windshield.

When investing in anything, real estate included, down payment isn’t leverage, nor does the size of the down payment indicate whether or not a particular investment will be successful or not. Sounds obvious, doesn’t it? But apparently not, as legions of self described investors have bitten the big green weenie as a direct result of what’s known as negative leverage. I speak from personal experience. Ouch.

Never heard of it? Don’t feel bad, most haven’t.

Positive Leverage: When the return on invested capital is greater than the cost of borrowed money.

Negative leverage is, of course, the opposite. This surprises people, but we can all go back in time to a loser investment, do the numbers, and see this particular law of investment physics illuminated. “Oh, man. I borrowed hard money at 13% and the dang house only returned 7% — no wonder it was a loser.”

What this means is that a deal calling for 50% down can end up as the best leveraged investment you ever made, while the 0-20% down deal — not so much. Again, don’t come away thinkin’ the down payment is the deciding factor, cuz it isn’t. It’s just a factor along with all the others which you, as an investor analyze when choosing which deal to take.

A Captain Obvious statement: Most of the time the return is less than the cost of our borrowed money cuz we either miscalculated the ‘built-in equity’ or projected appreciation that was, um, a no-show. It can also sneak up on us when we underestimate operating expenses or overestimate rents — or participate in Murphy’s Bonus Round by doing both. (Guilty as charged.)

This ruthless law is why, when doing serious analysis of potential deals in today’s market, the elimination of appreciation is critical. The same goes for buyin’ property at ‘impressive’ discounts — don’t eliminate them — just keep in mind it’s only impressive if you’re correct. Get your own boots on the ground when deciding rents and operating expenses. Don’t believe anyone, or anything but you’re own lyin’ eyes ‘n ears. 🙂

Most new investors think the reason they use ‘other people’s money’ is to ‘leverage’ the little money they have. They often learn the hard way that the cornerstone assumption of borrowed money is that the use of that money will generate a return exceeding the cost of that money.

The lesson I learned from violating this law — twice mind you — was simple as pie.

$0 down with borrowed money at 2% interest is a huge loser when the property’s return is 1%. Negative leverage. Yet a 50% down transaction with borrowed money at 20% interest with an ultimate return of 25% is a winner. Positive leverage.

This is what guys like Peter Giardini and Richard Warren are teaching constantly.

Listen to them and prosper. Don’t be a bug in search of a windshield.

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14 Comments

Jeff… great article… Leverage can one of those damned if you do and damned if you don’t propositions. The deals that scare me the most are those where an investor can get into them with no money down. For most investors jJust the thought of being able to own a property with no money out of their pocket seems to cause them to turn off their brain and just jump in… and later regret it.

Jeff,
My tiny little brain is taking some time to absorb this. If you have $0 into a deal that 2% interest and 1% return, are you saying negative cashflow? If so, that makes perfect sense to me. I’m afraid I’m staring at the picture to hard and its probably that simple.

Thanks Peter — To use a baseball analogy, treating leverage as primarily an issue of down payment size, is akin to judging a pitcher primarily by the velocity of his fastball. You’re gonna be wrong sometimes both ways.

Bilgefisher — The return is the return is the return. Sometimes it’s the cash flow that fails. Sometimes the exit price guts us. If it’s buy ‘n sell quick thing, maybe it was bought right, and sold for what the investor projected, but the fix-up costs were higher than projected. Sometimes it’s a buncha things gone bad. In the end, there’s an overall return. It’s either more or less than the cost of the investor’s borrowed money.

Makes sense. While obvious, what matters is the money at the end is greater then the money put in during the entire process. Leverage is simply another cost involved. It can help if the cost does not create a smaller amount of money then you started with.

Finally! A relevant, intelligent post about a topic that so much good judgment is missing. Thank you for sharing this creative and intelligent commentary with the world. We definitely need lot of common sense like you’ve got shown here. I appreciate it

Jeff, your posts tend to bring a smile on my face because of your fun use of analogies. This is a great advice that I’m striving to keep in mind as we’re growing our rental portfolio. My husband & I are taking the approach of owning fewer homes but having them free and clear within 5 years vs. 2 or 3 times the number of homes that are all highly leveraged for 15-30 years. It seems to be an uncommon approach, but having less debt and more cashflow is a winner in my book 🙂

Hi Shae — It depends upon the long term economic outlook. 25 years ago I’d of told you to buy young at a break-even cash flow then grow. That template worked for growing capital/equity from the 1960’s until the latest fiasco. Though there were (predictable) cycles, there wasn’t a change in the ‘norm’. Now though, we’ve entered IMHO, a different economic atmosphere. Doing it the way you’ve suggested will do you well, especially as it relates to the protection of your capital — a principle far too long ignored.